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March 2008 Health Benefits: Good News for Small Business Owners Two changes of position by the IRS expand the deductibility of health care coverage for the self-employed When it comes to tax-free fringe benefits, the tax law has long treated as non-employees any individuals who own more than a 2% interest in a subchapter S corporation. The consequence is that the health insurance benefits that an S corporation provides to its owners are not tax-free fringes; they have to be reported as compensation on the owners’ W-2s. In recent years, to offset the extra W-2 income, the owners could claim the 100% self-employed health insurance deduction. In the end, owners achieved the full deduction for their health care benefits, but only after jumping through a few hoops on their Form 1040. Policy ownership. To complicate matters further, the IRS has historically taken the position that a health insurance policy for an owner of an S corporation must be owned by the S corporation. The IRS had asserted that the S corporation could not simply reimburse the premium costs if the policy was owned by the individual shareholder. Now, in an important change in position, the IRS has conceded that it makes no difference whether the health insurance policy is owned by the S corporation or its owner. In either case, the S corporation may pay or reimburse the premium and, therefore, qualify the owner for full deductibility of that premium. Companies are still required to go through the steps of W-2 inclusion and claiming the offsetting deduction. However, at least the IRS has dropped its former position regarding the ownership of the health insurance policy. Further, if an S corporation shareholder did not claim the health insurance deduction in the past, due to this IRS position, but otherwise had the S corporation make the premium payment, amending the tax returns may be an option. Spousal health benefits. Many small businesses are organized as proprietorships (one owner) or partnerships. It is also common in those small businesses that the spouse of an owner may provide part- or full-time services to the business. In those cases, by formally employing that spouse it becomes possible for the business to provide tax-deductible health insurance, and sometimes additionally a medical reimbursement plan, both of which are tax-free fringe benefits to that spouse-employee. In the June 2007 issue of the Bottom Line we discussed the Francis case, in which the tax court scrutinized a spousal employment arrangement. That case disallowed the fringe benefits due to the inability of the taxpayer to document that (a) actual services were rendered by the spouse to the business and (b) the compensation and fringe benefit package were reasonable in exchange for the value of those services. Fortunately, in the November 2007 Frahm case, the tax court rebuffed IRS attempts to further narrow the spousal employment opportunity. The case involved a proprietor who employed his wife for part-time services. As part of that arrangement, the business deducted the premiums for several health insurance policies. In one case, the insurance policy was issued in the employee-spouse’s name, whereas another insurance policy was solely in the proprietor’s name. The tax court disagreed with the IRS position that the health policy in the proprietor’s name could not be part of the employee fringe benefit plan. Because the business had paid all of the premiums and did so under an employer-provided health plan arrangement, the proprietorship was allowed to claim all of the premiums as a business expense. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |